Last week, the Bank of England announced it would begin engaging in quantitative tightening. Unanimously, the Monetary Policy Committee voted to “reduce the stock of purchased UK government bonds, financed by the issuance of central bank reserves, by £80 billion over the next twelve months, to a total of £758 billion”. Essentially, the Bank would be flogging the bonds it had bought during the long period of quantitative easing.
So today’s news that the Bank of England is now embarking on the purchase of long-dated government gilts for at least the next two weeks is, in that favourite media catchphrase, a u-turn. The reason for it is that, as far as we know, the collapse in market confidence since Friday’s mini-budget and the attendant upwards pressure on the cost of borrowing has meant the pension market was coming under extreme pressure.
The Bank claimed has begun its process of gilt-purchasing because, in its absence, there would be a “material risk to UK financial stability”. It will now buy bonds at an “urgent pace” to help restore “orderly market conditions”. In doing so, it hopes to provide sufficient confidence for investors to stop demanding ever higher prices for lending. Already, gilt yields have fallen since the Bank intervened, and, though the pound remains record-breakingly weak, some semblance of normality is returning.
Broadly, this is positive for Trussonomics. The Bank continuing with its money-printing (which is essentially what this is) makes it cheaper and easier for the Government to borrow, as in the pandemic. The difference now, of course, is that the Government is not solely borrowing to get through a crisis – although that is the rationale behind the Energy Price Guarantee – but to finance the largest set of permanent tax cuts since the Barber Boom.
As our own Gerard Lyons indicated at the start of last month, engaging in a rapid programme of quantitative tightening with the economy as weak as it is can be just as disastrous as the failure to do so was last year when it was clear inflation was going to increase. Nevertheless, whilst today’s move may have checked the surge in borrowing costs in the immediate term, one needs to be aware that the Bank’s threatened quantitative tightening was one of several factors behind their spike.
One, as mentioned above, has been Bailey’s persistent failure as the Bank’s Governor to get a hold on inflation. The decision last week to raise interest rates by only 0.5 per cent – compared to a US Federal Reserve now habitually doing so by 0.75 per cent – spooked money men who had assumed the pace of getting a handle on inflation would be faster. Today’s decision will be welcomed by those who take it as Bailey and co finally being roused from their slumber.
Yet the other factor in the increase of the cost of yields is the £70 billion or so extra borrowing announced in the mini-budget. As long as the Government persists in pursuing tax cuts without the spending cuts or supply-side reforms the markets believe are needed for it to meet its obligations, the cost of borrowing will continue to increase, as investors remain unconvinced that Truss and Kwarteng understand budgetary probity.
With that we leave the realm of economics and enter that of politics. The last question to ask for the time being is: how high will interest rates go? Markets currently have priced in a peak of 5.8 per cent next July, up from 2.25 per cent today. Many think that is pessimistic, since the assumption is that faster action on Bailey’s part and falling energy prices might prevent the inflationary situation from getting out of hand.
But the truth is, only weeks ago, 5.8 per cent would have looked pessimistic. The situation is evolving hourly. Current falls in energy prices might not survive if Putin is sabotaging the Nord Stream pipelines. We cannot know what the policy, the pound, or prices will look like next week, let alone next year.
In my normal cheery way, the assumption I have been making for the last few months is that the worst situation is usually the most likely. I haven’t been surprised yet.